Sunday, May 30, 2010

Stock market returns

Lately Felix Salmon has been arguing against investing in stocks. Some of his arguments make sense, others not so much. Here for example Salmon claims in part:

A lot of people like investing in stocks because the stock market has, in the US, and over the past couple of generations, managed to outperform GDP growth. But that’s not sustainable over the long term. ...

This is one of those assertions which is superficially plausible but falls apart when you start to think about it. Consider for example a steady state economy where GDP is not growing. Does this mean stocks would have to return nothing? I don't see why. Stocks could pay say a 3% annual dividend while not increasing in value. Thus returning 3% a year. Which is more than zero.

Saturday, May 29, 2010

Martin Gardner RIP

Martin Gardner died last Saturday . He wrote the Mathematical Games column in Scientific American from 1956 to 1981 and several books of collected columns (as well as many other books). I enjoyed his recreational mathematics works while growing up and they probably influenced me towards a career in mathematics.

Dick Francis RIP

Dick Francis died a few months ago . He was a British jockey who became an author writing about 40 novels starting with "Dead Cert" in 1962. The novels were in the mystery/crime/adventure/thriller genre which I favor and often drew on his horse racing background. They were a bit formulaic but I liked the formula especially in the earlier books.

Sunday, May 23, 2010

Value creation

In my mortgage math post, I claimed that:

... The main incentive for making financial products complicated is to make them hard to value and thus easier to sell for more than they are worth. ...

A commenter responded in part:

Maybe I've just bought into the hype, but I was under the impression that, at least in some cases, the complex, derivative whole can be more than the sum of its simple, nonderivative parts, because different investors, due to their different circumstances, differ in their valuation of the derivative pieces.

I am not claiming that complexity never adds value (or that it is theoretically impossible or anything like that) just that in practice the apparent value added often turns out to have been illusory. And that this was the case for the mortgage backed securities that recently proved so problematic.

Now obviously these products were being created because they could be sold for more than their cost. Cost being the amount required to purchase the underlying mortgages plus the fees and overhead required to create and sell the derivative securities. So investors in these securities did think value was being created. But they were mistaken. The buyers were relying on the credit ratings of the securities and these ratings were optimistic. This is not too surprising. The people creating these securities could test a million different ways of reassigning cash flows to create derivative securities, examine the resulting ratings (they had access to the rating company software) and pick the assignment that gave the highest combined value to the derivative securities created. Now if the ratings had been perfect this would not have been a problem but of course the ratings were far from perfect and this procedure found the cases where the ratings were most inflated (whether from model flaws or actual bugs in the software). The security buyers didn't adequately discount for this effect and thus overpaid. I believe any actual value created was generally less than the extra overhead costs so that these securities had little real reason to exist and will largely disappear now that buyers are more wary.

Another related problem with these products is that they turned out to have no effective defense against fraud in and/or misrepresentation of the underlying mortgages. The mortgage brokers who arranged the mortgages had no incentive to see that the buyer's income and credit rating and the appraised value and sales price of the property were accurately reported since the more inflated these values were the more they could resell the mortgage for. And the resale price directly impacted the broker's income since they could give a mortgage for $200000, resell it for $220000 (if the buyer's monthly payment would actually have supported the larger mortgage in the current mortgage market) and pocket the $20000 difference. Again the rating agencies and buyers relying on the ratings didn't adequately allow for this effect which got steadily worse as underwriting standards completely collapsed during the housing bubble. Of course this could have been a problem with simple mortgage pools as well but I believe the greater distance between the ultimate buyer and the underlying mortgages made things worse.

Friday, May 21, 2010


I thought this post about Thailand by John Hempton of Bronte Capital was interesting.

Thursday, May 20, 2010

U is for Undertow

I recently read "U is for Undertow" by Sue Grafton. This is the latest book in her alphabet series about Southern California private investigator Kinsey Millhone. The series started with "'A' is for Alibi" (1982) and "'B' is for Burglar" (1985) both of which I quite liked. I have read the rest as they came out but have felt for some time that the series has been gradually going downhill, an opinion that this book didn't change.

I am a little unsure of exactly why I haven't liked the later books as much but there are a few things I can point to. In the first book Kinsey is 32 in 1982, in the latest she is 38 in 1988. So the the setting of the books has increasingly diverged from the present. I generally prefer books that are set in the present (meaning the same time as they are written). Of course this is a problem with a long running series character but I think I prefer the alternative choice where the setting stays in the present and the character ages slower than normal people. Another consequence of this being a long running series is that a lot of back story has accumulated and tends to get repeated for new readers which I find tedious. Also the latest book is 403 pages while the first two were 215 and 211. This is a little misleading as the earlier books have more lines per page, still they are substantially shorter. I find established authors (Steven King for example) have a tendency to become excessively prolix, perhaps because they no longer have to listen to their editors. I think shorter is often better.

So in summary, like Iron River , this isn't a terrible book, but if you want to give this series a try I would start at the beginning.

Wednesday, May 19, 2010


I was surprised to read Josh Marshall feeling sorry for Arlen Specter in anticipation of his defeat in Tuesday's primary. I don't have anything much against Specter but it seems to me that there are lots of people more deserving of pity than an eighty old, five term Senator, defeated in a bid for a sixth term.

Saturday, May 15, 2010

Mortgage math

Matthew Yglesias discusses a simplified model of mortgage based structured financial products (CDOs and CDOs2) posted by Alex Tabarrok taken from a book by Robert Pozen. The model shows how structured finance can transform a collection of moderately risky mortgages into securities some of which are intended to be quite safe and others of which are intended to be quite risky by assigning defaults to the risky securities first. Not surprisingly if defaults turn out to be higher than expected some of the "safe" securities can prove risky.

Yglesias says "Importantly, this is not a scam. The math really checks out. ...". The math may check out but I think it is largely besides the point and these products were essentially scams. The main incentive for making financial products complicated is to make them hard to value and thus easier to sell for more than they are worth. Here the optimistic model assumptions which led to these securities being overvalued were not some unfortunate accident but a necessary part of the scheme. There is in fact no compelling reason to reassign the risk of defaults in this way. So if the complicated structured finance securities were valued correctly they would not be worth more than simple pools of their component mortgages meaning there would be no incentive to create them.

Sunday, May 9, 2010

Greece and Europe

It has recently become very apparent that expanding the Euro zone to include countries like Greece was a mistake . This mistake seems to me to be one of elevating form over substance, if you put Greece in the Euro zone this will somehow magically transform Greece into a country which belongs in the Euro zone. You see this thinking in other contexts, admitting this student to an elite university or placing this applicant in a demanding job will magically make them capable of performing well. As with Greece and the Euro things often don't work out, particularly when the risks are ignored.

Wednesday, May 5, 2010

Iron River

I recently read "Iron River" by T. Jefferson Parker. This is Parker's 17th book and I like him well enough to have read most (if not all) of them. However I have liked some of them more than others and this is one of the ones I didn't like so much.

The plot mostly concerns the efforts of a southern California ATFE agent, Charlie Hood, to stop the "iron river" of guns flowing south to Mexico. Hood and some of the other characters have appeared in at least one earlier book (although this book is largely independent). I don't think these books are Parker's best. Perhaps because they contain mystical elements and other unrealistic plot points. Or perhaps because they are more morally ambiguous than I generally prefer. Anyway this isn't a terrible book but there are authors I like better than Parker and books of his that I like better than this one.

Sunday, May 2, 2010

California insanity

Apologists for California's politicians sometimes blame the state's problems on its initiative process. I was never very sympathetic to this argument and am less so after learning via Kevin Drum that California, which you may have heard has budget problems, recently extended and expanded a tax credit bonus for home buyers.

Only two Assembly members and one senator voted against the bill.

It would appear the California legislature is full of pandering idiots and that this probably has something to do with the state's problems.

As well as being terrible public policy in general, the specifics of the programs are also objectionable. As can be seen here and here (pdf file) you have to jump through a number of hoops to actually collect the credit. So it disproportionately benefits agile insiders. And of course nonrefundable tax credits (like these) favor the rich.

Saturday, May 1, 2010

Health insurance vrs life insurance

The issue arose in comments as to whether the fact that the individual health insurance market doesn't work very well is a sign of economic inefficiently. Not by itself. Something is considered economically inefficiently only if there is a better way of doing it. While there are probably numerous ways the individual health insurance market could be made to function better, many of its problems are fundamental. Health care and insurance are just not a very good fit.

In my view the ideal insurable risk has the following features. There is a small risk of a large economic loss. The loss while large is strictly bounded. Most losses are total. It is clear cut whether the loss has occurred. Losses are easily computed and paid off in money terms. Losses are difficult to fake or arrange. Losses for different people occur independently. The true risk can be easily and accurately determined. The true risk is largely independent of whether the individual is insured. The insured individual does not have a significant advantage (compared to an insurance company) in determining the true risk. The true risk itself behaves predictably over time. It is possible to charge rates which reflect the true risk.

I think it should be fairly clear why these are desirable features. For example insured individuals and insurance companies don't trust each other. So the fewer things to argue about the better. Hence it is desirable that losses be rare and clear cut.

It should also be clear that individual health insurance (particularly as currently provided) is not a very ideal insurance product by these criteria. Life insurance on the other hand scores better. So it should be no surprise that the life insurance market functions better.